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Newswise — The pain of foreclosure doesn’t end with the individual families who lose their homes. Foreclosures depress communities and economies. But how does one measure the direct impact of foreclosures on the overall economy? The problem is complicated by the fact that other economic shocks – such as job losses – could be jointly driving up foreclosures and driving down economic growth.

In Foreclosures, House Prices, and the Real Economy, UC Berkeley economist Atif Mian and co-authors Amir Sufi and Francesco Trebbi exploit legal differences across states in how mortgage defaults are handled. States in the US are divided into two camps. Some – like Illinois – are judicial, meaning the lender is obligated to go through the court before foreclosing on a home. Others – like California – have no such requirement, making it much easier for banks to foreclose delinquent homes.

“The bottom line of this work is that we should design our bankruptcy system in terms of how the overall economy responds to financial shocks. This paper forces us to think more carefully about the exact designs of bankruptcy regulations,” says Mian.

Mian is an associate professor and co-chair of the Fisher Center for Real Estate & Urban Economics at the University of California, Berkeley’s Haas School of Business. Amir Sufi is an associate professor, University of Chicago’s Booth School of Business and Francesco Trebbi is an assistant professor, University of British Columbia.

“What we found is not only do these neighborhoods that do not require a judicial process have higher rates of foreclosure but as a result, they have a much steeper decline in housing prices and real outcomes”, says Mian. “It’s possible that the further decline of the broader economy makes people feel less wealthy and so they start becoming more cautious with new investments and buying debt.”

The rate of foreclosure per delinquent home in 2008 and 2009 is twice as high in non-judicial states. A delinquent home has a nineteen percent chance of being foreclosed in a judicial state, but thirty eight percent in a non-judicial state.

Key to this finding is that Mian and his colleagues isolated the judicial requirement when comparing states. Other than that attribute, all the states share similar characteristics: the fraction of subprime borrowers, the fraction of lower income residents, the unemployment rate, the minority share of the population, the fraction of urban residents, credit growth, and growth in housing prices.

In the areas of residential investment and the consumption of durable goods, the study found a one standard deviation increase in foreclosures per homeowner leads to a larger two-thirds standard deviation decline in new residential construction permits and auto sales.

Based on these outcomes, Mian says estimates suggest that 15 percent to 30 percent of the dramatic decline in both residential investment and 2 percent to 40 percent of the decline in auto sales during the two-year period can be blamed on foreclosures.